8.The improving market provides both seller and buyer growth leverage. When negotiating earnout component, buyers will be very generous in future compensation if acquired company exceeds their projections. Projections that look very aggressive for seller with their pre-merger resources, suddenly become quite attainable as part of a new company entering a period of growth. An example might look like this: Oracle acquires a small software Company B that has developed Oracle conversion and integration software tools. Last year Company B had sales of $8 million and EBITDA of $1 million. Company B had grown by 20% per year. The purchase transaction was structured to provide Company B $8 million of Oracle stock and $2 million cash at close plus an earnout that would pay Company B a % of $1 million a year for next 3 years based on their achieving a 30% compound growth rate in sales. If Company B hit sales of $10.4, $13.52, and $17.58 million respectively for next 3 years, they would collect another $3 million in transaction value. The seller now expands his client base from 200 to 100,000 installed accounts and his sales force from 4 to 5,000. Those targets should be very easy to hit. If these targets are met, buyer easily finances earnout with extra profit.

9.The window of opportunity in technology area opens and closes very quickly. An earnout structure can allow both buyer and seller to benefit. If smaller company has developed a winning technology, they usually have a short period of time to establish a lead in market. If they are addressing a compelling technology gap, odds are that companies both large and small are developing their own solution simultaneously. The seller wants to develop potential of product and achieve sales numbers to drive up company’s selling price. They do not have distribution channels, resources, or time to compete with a larger company with a similar solution looking to establish industry standard. A larger acquiring company recognizes this first mover advantage and is willing to pay a buy versus build premium to reduce their time to market. The seller wants a large premium while buyer is not willing to pay full value for projections with stock and cash at close. The solution: an earnout for seller that handsomely rewards him for meeting those projections. He gets resources and distribution capability of buyer so product can reach standard setting critical mass before another large company can knock it off. The buyer gets to market quicker and achieves first mover advantage while incurring only a portion of risk of new product development and introduction.

10.You never can forget about taxes. Earnouts provide a vehicle to defer and reduce seller’s tax liability. Be sure to discuss your potential deal structure and tax consequences with your advisors before final negotiations begin. A properly structured earnout could save you significant tax dollars.

Smaller technology companies have many characteristics that make them good candidates for earnouts in sale transactions: 1. High growth rates, 2. Earnings not supportive of maximum valuations, 3. Limited window of opportunity to achieve meaningful market penetration, 4. Buyers less willing to pay for future potential entirely at sale closing and 5. A valuation expectation far greater than those supported by buyers. It really comes down to how confident seller is in performance of his company in post sale environment. If earnout targets are reasonably attainable and earnout compensates him for at risk portion of transaction value, a seller can significantly improve likelihood of a sale closing and transaction value.